An equity analyst is valuing a listed company that is expected to generate EBIT from year 1 onwards as given in Table 1.

Table 1

Year 1	Year 2	Year 3	Year 4	Year 5
€16000	€18200	€16480	€17100	€17500

The EBIT margin is expected to be stable at 9.5% of sales from year 2 until year 5. The expected level of sales for year 1 is €160000. Additional assumptions are:

• Depreciation: 6% of sales, all years
• Recurrent Capex: 8% of sales for year 1, with percentage decreasing 35 basis points (0.35%) per year until year 4
• Change in working capital: 15% of yearly changes of EBIT
• Tax rate: 20%
• Target capital structure: debt/(debt + equity) ratio of 60%
• Asset beta: 1.4
• Risk-free rate: 2%
• Equity risk premium: 6%
• Debt spread: 4%
• Expected level of interest bearing debt at end of year 1: €30000
• Expected level of cash at the end of year 1: €12500
• Expected level of financial investments at the end of year 1: €15000

To answer the following questions make plausible assumptions if necessary. In case you prefer, standard characters can be used (e.g b rather than β, capital_sigma rather than ∑).

1. Compute the Free Cash Flows to the Firm (FCF) for the period from year 1 until year 5, including year 5. Explain your answer. [10 marks]

It is often recognised that there exists an optimal capital structure (debt versus equity), that maximises the value of the company. Explain why, up until a certain level of debt, more debt increases the value of the company and, above that level, an increase in debt is expected to destroy value (everything else being constant). [10 marks]

3. Given the target capital structure and the set of assumptions reported below Table 1, what is the discount rate to be used in this valuation exercise? Explain your answer. [10 marks]

4. A validity condition to use the FCF model is the stability of capital structure. Do you agree? Explain your answer. [10 marks]

5. The expected nominal growth rate of FCF in perpetuity is 1.25% and the current market capitalization of the company under analysis is €115000. What would be the equity analyst investment recommendation? Explain your answer.

Answer rating: 100% (QA)

To compute the Free Cash Flows to the Firm FCF for the period from year 1 until year 5 we need to calculate the following components 1 EBIT Earnings B... View the full answer